Outlook: Solid U.S. Economic Momentum Poised to Cool in 2019

On the business front, investment has strengthened in response to fiscal stimulus, solid global growth, and stronger energy sector activity.

U.S. economic growth is expected to continue in 2019, while outlooks for the aerospace and defense, automotive, energy and medical industries vary.

Economic momentum has been solid through the first three quarters of 2018. Real GDP growth is poised to average almost 3.0% this year, reaching its strongest growth pace since 2005.

On the household front, a robust labor market will deliver over two million new jobs for an eighth consecutive year, as the tighter labor market also gradually pushes up wage growth to its fastest pace in nine years. Rising income growth and a reduced tax burden have supported solid consumer spending growth of around 2.5-3.0% year/year—while keeping the personal savings rate healthy and stable for a fifth straight year.

On the business front, investment has strengthened in response to fiscal stimulus, solid global growth, and stronger energy sector activity. With the impetus from tax cuts and expensing allowances likely to fade, we see business investment growth around 7.0% this year, gradually slowing to an average 3.5% in 2019. Residential investment, on the other hand, is expected to be roughly neutral to growth in 2018 and 2019. Despite pent-up demand for new homes, cost pressures, labor shortages and lot shortages are constraining homebuilders and new home construction.

GDP Growth to Ease

Looking ahead, we see average real GDP growth easing from nearly 3.0% in 2018 down to around 2.5% in 2019. Fiscal stimulus will continue to underpin sturdy economic momentum, though the marginal impact will be modestly lower next year. We expect the boost from fiscal stimulus to fall from 0.7pp (percentage points) in 2018 down to 0.5pp in 2019.

Average real GDP growth easing from nearly 3.0% in 2018 down to around 2.5% in 2019.

At the same time, increased protectionism and the trade war against China will weigh on net trade, while the uncertainty it creates will also cap business investment growth. The U.S. has imposed tariffs on $250 billion of imports in China, amounting to about half of all merchandise imports from the country. China, on the other hand, has imposed tariffs on $110 billion, nearly 80%, of U.S. merchandise exports.

These tariffs are already having a visible impact on trade flows with exports falling by the most since the 2015 global growth lull. At the same time, a rising number of U.S. firms are reporting plans to reduce or delay capital expenditures amid the heightened trade tensions. Altogether, we estimate around a 0.2pp drag on real GDP growth in 2019 as a result of the escalating tensions. Importantly, U.S. households can also expect to face higher prices for common goods. Since the U.S. production apparatus is not geared towards producing most goods imported from China, import substitution will not be a readily available solution.

Elsewhere on the trade front, the United States-Mexico-Canada Agreement (USMCA) will replace and modernize NAFTA. While politicians on all sides tout a hard-fought victory, the economics remain little changed. In the short-term, the deal lets markets and businesses breathe easy following concerns that the U.S. would exit the agreement. The substance of the USMCA has not caused us to alter our growth forecast.

Amid increasing tightness in the labor market and rising inflation, monetary policymakers at the Federal Reserve have turned increasingly hawkish. We look for sustained inflation momentum around the Federal Reserve’s 2% target heading into 2019.

Indeed, recent comments suggest that Federal Open Market Committee (FOMC) participants generally agree that inflation is “on a trajectory to achieve the symmetric 2% objective on a sustained basis.” With the Fed expected to implement this year’s fourth rate hike in December, we look for three additional federal funds rate hikes in 2019. Alongside more restrictive trade policy, we expect a modest drag from tighter monetary policy in 2019 to gradually turn the policy mix less favorable in the next eighteen months.

Risks on the Horizon

Resilient economic momentum has kept the U.S. economy insulated from ongoing emerging EM woes. Looking ahead, while the economy remains well insulated from idiosyncratic EM shocks—given limited trade, banking and corporate exposures to the riskiest EMs—a generalized EM slowdown would constrain the U.S. economy. In 2015-16, during the last generalized EM slowdown, we estimate the drag on U.S. GDP growth amounted to about 0.6pp—enough to disrupt today’s solid pace of activity.

At the same time, financial asset prices remain near-record highs, despite the recent spike in volatility. After years of ultra-low interest rates and globally accommodative monetary policy, equity market valuations are at multi-decade highs, increasing the risk of correction.

We estimate a sustained 10% fall in equity prices would reduce U.S. consumer spending growth by 0.8pp and cut real GDP growth by 0.6pp. While the initial wealth effect of a stock market correction would be concentrated on the top 40% of income earners, the bottom 60% would be disproportionately affected by reduced employment, low wage growth and a negative confidence shock.

More recently, oil prices have risen alongside asset prices, creating another headwind for the U.S. economy. Higher oil prices are still a net negative for the U.S. economy, but less so than a decade ago. The drag on consumer spending remains significant, but the importance of shale activity means there is now a greater boost from business investment. We estimate the net drag from higher oil prices could lower real GDP growth by about 0.3pp in 2018, offsetting nearly half of the fiscal stimulus.

Aerospace: Structural Tailwinds Outweigh Cyclical Pressures

Recent annual benchmark revisions to Federal Reserve data have markedly changed the profile of aerospace output in recent years. Output growth in 2017 was much stronger than expected, increasing by 0.4% (from a previously recorded 2.6% contraction). However, the trend was deteriorating at the end of the year and that deceleration has gathered pace so far in 2018.

Supply chain issues at Boeing have caused the company’s deliveries to hold roughly flat compared to the year-ago period, despite strong new orders. Overall, we expect a gradual pickup in Boeing deliveries in the balance of the year to keep the contraction in aerospace activity around 2.0% in 2018, before a gradually turning defense cycle and a significant backlog in civilian aircraft combine to push growth back above 2.5% in 2019.

While near-term uncertainty has caused doubt surrounding U.S. competitiveness in aerospace, the country maintains a strong and influential position in the global industry. The U.S. accounts for half of global aerospace production, an especially advantageous position in an environment in which global air travel has grown at a solid 6-7% annual pace since the depths of the financial crisis. Lower air travel costs and increasing incomes for middle-class families are expected to continue to support global air travel.

In the near-term, however, the administration’s travel restrictions on Middle Eastern countries may weigh on the domestic industry, reducing passenger volumes. Other relevant threats include pressure for aircraft manufacturers to invest in efforts to improve fuel efficiency and reduce noise and other pollution. Climate-change control measures are an additional drag on airlines’ profitability, despite counter-proposals by President Trump and the International Civil Aviation Organization (ICAO).

In the key global defense subsector—which comprises about a quarter of total aerospace output—the U.S. enjoys an even stronger competitive position with over a 60% share of global sales. However, President Trump’s policy stance looks increasingly damaging for U.S. defense prospects. Tariffs on steel and aluminum could result in higher costs for weapons systems, including the F-35 and other advanced aircraft. This increasingly protectionist stance could also trigger retaliatory tariffs against U.S. aerospace defense firms and erode competitiveness.

Overall, the structural drivers outweigh the cyclical risks. We remain optimistic about U.S. competitiveness in aerospace and defense given (i) its reputation as a reliable and safe producer relative to China, (ii) favorable fundamental indicators (e.g., output per unit of capital and labor) compared to European manufacturers, and (iii) its history as the birthplace of aviation. We forecast U.S. aerospace production to grow at a solid 3.5% annual clip over the next decade, outpacing real GDP growth by nearly a full percentage point.

Automotive: After Solid Growth in ’18 Expect Deceleration in ’19

The U.S. automotive industry is on track to return to growth in 2018. After contracting 0.7% in 2017, we forecast value-added output growth north of 3.0% driven by a rebound for Fiat Chrysler as its plants resume operations and a bounce-back for Honda after several key new model introductions. However, output will once again be impacted by new model changeovers in 2019.

Rising income growth and a reduced tax burden have supported solid consumer spending growth of around 2.5-3.0% year/year—while keeping the personal savings rate healthy and stable for a fifth straight year.

Most notably, Ford’s Michigan assembly plant will shift Ford Focus production to China and drop the C‐Max to make room for the higher-margin Ranger midsize pickup. At the same time, the domestic industry will be impacted by slowing demand as rising interest rates, tighter credit, and higher used‐car prices are likely to erode buying conditions. Overall, we see value-added output decelerating down to 0.2% in 2019—though trade protectionism remains an important downside risk.

The Trump administration’s national security investigations into automotive imports threatens a retaliation from Germany, Italy, the UK, Canada, and Mexico and risks impeding sustained industry growth. Meanwhile, cautious producers may opt to delay investment decisions until trade policy uncertainty is reduced. On this front, the recent announcement of the USMCA should restore some confidence, though we note Congress may not vote to fully pass the measure until early in 2019.

Offsetting some of the downside risk from trade policy is sustained momentum in key growth drivers. First, persistent employment and gradual disposable income growth continue to make motor vehicles more affordable for consumers.

At the same time, the multi-year trend away from cars and toward crossovers, SUVs and pickup trucks has continued unabated in 2018. This vehicle mix is bolstering OEM profitability and improving industry fundamentals.

All the while, innovative start-ups with state-of-the-art powertrain and vehicle ownership models are looking to disrupt industry stalwarts. On this front, General Motors’ sale of its European operations may signal further cost-cutting and plant rationalization measures, while also prompting more M&A activity from large OEMs.

With the Big Three U.S. automakers’ domestic market share shrinking from 70% in 2000 to 45% in 2014, worries continue to mount about U.S. competitiveness. The growing trade deficit and shifting supply chains outside of the U.S. have done little to stem these concerns. However, U.S. share of global production has in fact been relatively stable over the past three decades, hovering steadily at a long-term average of 20%.

Indeed, the U.S. has fared much better than other past automotive powerhouses. Japan, for instance, has seen its share of global production gradually decline, down about 15pp in 25 years due to lower-cost competitors in South Korea and China. Germany has suffered a similar fate, losing share to cheaper Eastern European producers.

Increasing domestic labor productivity, which is up over 4% a year since 2000, is one way the U.S. has remained competitive, combining the latest automation technologies with a higher-cost, but skilled labor force.

In the broader trade picture, while it is true that the U.S. automotive sector generates a $100 billion trade deficit each year, the rising imports are due to rapidly increasing U.S. automotive demand. Amid climbing domestic demand, there is evidence of enhanced U.S. competitiveness, with the imports penetration rate actually declining in recent years, down to around 20%.

Importantly, the U.S. is also appealing as a manufacturing hub for foreign producers. In 2014, 36% of U.S. automotive output was from foreign-owned firms, up by 23% from 2007, and expectations are that this share will continue to rise. The administration’s protectionist policies may coerce foreign firms to further invest in the U.S.

Energy: Higher Prices Drive a Cyclical Industry Upturn

After a solid year of 7% growth in 2017, value-added output in the U.S. oil and gas extraction industry is poised to grow more than 12% in 2018. Driven largely by higher crude oil prices, the industry has seen a boom in production in the U.S. tight oil sector (oil embedded in low-permeable shale, sandstone and carbonate rock formations). Extraction has also been lifted by a strong upswing in oil services.

Driven largely by higher crude oil prices, the industry has seen a boom in production in the U.S. tight oil sector (oil embedded in low-permeable shale, sandstone and carbonate rock formations).

While the oil rig count has been on a steady upward trend in recent years and productivity has increased in key production regions, the industry will not be able to meet solid demand growth in the near-term. One key reason for this is that the industry is experiencing infrastructure bottlenecks that are limiting the ability to ramp up production further. While investments are being made to overcome this constraint, it will not be fixed in the short term. Looking ahead, we see value-added output growth decelerating to around 3% in 2019.

Underpinning our industry outlook is a commodity price forecast that sees crude oil prices soon reaching a peak, before trending lower in 2020-21. We look for Brent crude prices to average $77 a barrel in 2019, before easing to $73 per barrel in 2021. In 2018, fears about supply shortages helped boost oil prices as consumers are starting to get concerned about the potential disruptions of U.S. sanctions on Iran. Oil exports from Iran have already started to fall and tighter sanctions will kick in later in 2018. More bearish, though, is that production from Saudi Arabia and the U.S. is rising quickly to compensate. While demand growth has remained strong—particularly in key consuming areas such as China and the U.S., we expect a gradual slowdown in demand growth.

The medical sector is much less cyclical than the automotive and energy spaces. The general detachment from the economic cycle is a result of the public sector’s involvement in financing healthcare spending.

In addition, longer-term demographic dynamics are supportive of above-GDP growth in the medical industry. An aging population will continue to drive above-trend spending growth as the population aged 65 or older grows over 1% per annum through 2050.

On the downside, however, the industry remains quite prone to policy risk. After early attempts to repeal the Affordable Care Act, the current administration has shifted focus elsewhere. While this reduces near-term risk for the industry the threat of future policy changes looms. General efforts pertaining to entitlement spending containment threaten to impact investment growth in the medical space.